Japan-Iran Oil Ties Go Dry

by THOMAS STROUSE in Washington, D.C.

Large Asian and European companies involved in Iran's oil and gas sector are showing signs that they are preparing to withdraw from Iranian projects to avoid being targeted by U.S. sanctions. As Stuart Levey, the U.S. Treasury Department's point man on sanctions, explained in a presentation in Washington last month, the tendency of sanctioned Iranian entities to use deception to evade sanctions has provided U.S. authorities with an opportunity to also target legitimate Iranian transactions. "Because many in the private sector are simply unable to distinguish between Iran's legitimate and illicit transactions, they have opted to cut off Iran entirely," Levey said.

Japan's Inpex Corporation is the latest company that is reportedly considering withdrawing from a major energy project at Iran's Azadegan oil field. If Inpex does withdraw, it remains unclear what impact this will have on the future of the project. The development of the field is vital to Iran's ambitions to increase oil production, or at the very least, arrest declines in production over the next several years.

Azadegan, discovered in 1999, is Iran's largest onshore oil field, with reserves estimated at around 26 billion barrels. It is located in western Iran, close to the Iraqi border. The field contains sizable estimated reserves, but the reservoir is geologically complex, making extraction difficult. It is believed that around 6 billion barrels are recoverable. As a result of the complex geological nature of Azadegan, Iran has to rely on foreign technology and expertise for the successful development of the field.

The development contract for the field was signed in February 2004, forming a partnership between Japan's Inpex and the National Iranian Oil Company (NIOC). Inpex took a 75 percent stake in the project and NIOC took the remaining 25 percent.

The project has faced a number of setbacks, with progress much slower than originally planned. Iran had hoped to reach 150,000 barrels per day (b/d) of crude oil production by 2008 and 260,000 b/d by 2012. By the early part of 2008, production had reached only 10,000 b/d. By most accounts, the field is currently producing around 50,000 b/d.

The $2 billion agreement to develop the field was politicized from the start. Amid strong U.S. objections to the deal, an agreement was eventually signed after three years of tough negotiations between Inpex and Iran's Oil Ministry. By October 2006, Inpex had reduced its stake in the project from 75 percent to 10 percent, ceding its role as operating company to Iran's Naftiran Intertrade Company (NICO), a wholly owned subsidiary of NIOC. Inpex had trouble finding an international partner to assist it with the project and the United States maintained significant pressure on the Japanese government to limit its investment activity in Iran's oil sector.

Japan's Kyodo News reported on September 30 that the Japanese government and Inpex have reportedly decided to withdraw from the Azadegan project in an attempt to avoid being targeted by U.S. sanctions that could affect the company's development projects in other countries as well as transactions with American banks and other financial institutions. Akihiro Ohata, Japan's trade minister, confirmed to reporters that Inpex is considering withdrawing from the project. The Kyodo report suggested that negotiations may take some time because Iran will likely seek compensation for the withdrawal.

A spokesman for Inpex told AFP that the company has yet to make a final decision, but after Japan imposed its own sanctions on Iran in early September, "the government told us to deal with the project with great care." The spokesman, Kazuya Honda, added that it is company policy to consult closely with the Japanese government on the project in Iran. According to Inpex's website, Japan's Ministry of Economy, Trade, and Industry (METI) is the company's largest shareholder, with a 29.4 percent stake.

As Japan's largest oil explorer, Inpex has a number of projects around the world, including in Australia, Brazil, Canada, Egypt, and the UAE. Although relatively minor, the company has also participated in oil and gas development projects in the U.S. Gulf of Mexico since April 2006.

At a briefing on September 30, U.S. Deputy Secretary of State James Steinberg announced that the Obama administration had received "commitments" from four European companies "to terminate their investments and avoid any new activity in Iran's energy sector." The four companies named were Royal Dutch Shell, Italy's ENI, Norway's Statoil, and France's Total.

Trade Minister Ohata told Reuters the following day that Inpex was not among the companies listed as subject to U.S. sanctions, nor was it among those named as not subject to sanctions. "We are relieved that Inpex is not on the sanctions list," he said. However, at Steinberg's briefing, it was announced that the State Department has decided to impose sanctions on NICO for its involvement in Iran's energy sector. As a Swiss-based subsidiary of the National Iranian Oil Company, NICO plays a key role as a reputable corporate entity outside of Iran's own jurisdiction. NICO also happens to be Inpex's senior partner in the Azadegan project.

The State Department's action last week appears to be aimed at deterring non-U.S. private sector companies from doing business with NICO, under the threat that any defiant firm will come under intense scrutiny by U.S. authorities, essentially blurring the line "between Iran's legitimate and illicit transactions," as Levey has advocated.

After Japan imposed unilateral sanctions against Iran in early September, Ramin Mehmanparast, the Iranian Foreign Ministry spokesman, said that any country that imposes sanctions is depriving itself of exploiting Iran's high potential. "By taking such measures, these countries not only will cause problems for their own companies and national interests, but also will pave the way for the presence of their rival states," Mehmanparast was quoted as saying by the official IRNA news agency.

At his weekly press briefing on October 5, Mehmanparast explicitly warned the Japanese government that it should not submit to U.S. pressure to exit the Azadegan project. "They know that other countries and companies will immediately replace them and other rivals will appear in this field," Mehmanparast declared.

Despite exuding confidence in Iran's ability to find other foreign investors and easily counter U.S. sanctions, the groundwork for one of Japan's rivals to potentially fill the gap has actually been being laid for the past couple years. The state-run China National Petroleum Corporation (CNPC) signed a deal in January 2009 for the development of Iran's North Azadegan oil field, a smaller neighbor of the main Azadegan field -- which is, more precisely, the South Azadegan field. According to the January 2009 agreement, the northern field is to produce 75,000 b/d after four years and eventually reach an output of 120,000 b/d.

In addition to the agreement for the North Azadegan field, CNPC is in the process of completing a master development plan for the main Azadegan field. A memorandum of understanding signed in July 2009 between CNPC and NIOC laid out a nonbinding plan in which NICO would cede a 70 percent stake in the project -- out of its 90 percent total -- to CNPC, relinquishing control as the operating company. CNPC has promised to provide 90 percent of the development costs in financing the project. If both sides proceed with the deal, it is plausible that the development plans for the main Azadegan field and the smaller North Azadegan field could be combined.

If Inpex does completely withdraw from Azadegan, it will be a blow to the Japanese government's ambitious goal to have domestic companies produce overseas, as part of Japanese-owned concessions, 40 percent of the country's total oil imports by 2030. Since Japan lacks domestic oil resources, the government encourages domestic firms to increase their involvement in international oil and gas projects in order to guarantee a stable supply of energy for future generations.

Despite its reported intention to withdraw from Azadegan, Japan has no intention of halting its oil imports from Iran. For the past several years, Japan has been one of the three largest purchasers of Iranian crude oil, along with China and India. These three markets account for more than half of Iran's total oil exports. According to calculations based on government data, China imported an average of around 463,000 b/d from Iran in 2009, India imported 426,000 b/d, and Japan imported 421,000 b/d. That last figure represents a significant reduction relative to the recent past -- Japan imported an annual average of at least 500,000 b/d from Iran during the several years prior to 2009.

During the first eight months of 2010, for which reliable data is now available, the reduction in imports by two of Iran's top purchasers of oil, Japan and China, comes to nearly 200,000 b/d. According to Japan's METI, from January to August, Japan imported around 365,000 b/d from Iran. During the same period last year, Japan imported an average of 435,000 b/d. As Tehran Bureau reported on September 24, from January to August of this year, China imported around 391,000 b/d from Iran. During the same period last year, China imported an average of 519,000 b/d.

That leaves a lot of unsold barrels of Iranian crude oil, which are either finding their way to other markets or being used to satisfy rising domestic energy consumption -- or they can be attributed to Iran's higher than average level of floating storage of crude oil throughout 2010, compared to previous years. Industry reports have suggested that Iran is currently storing some 20 million barrels of crude oil in tankers anchored offshore in the Persian Gulf and elsewhere. While there are likely a number of reasons for this, including less demand for Iran's heavy crude and Asian refinery maintenance, it is also true that sanctions have made sales of Iranian oil more difficult in both Asian and European markets. Sanctions do not directly target Iran's oil sales, but restrictions on banks have made it difficult for purchasers to secure letters of credit to finance Iranian shipments. Additionally, insurance and shipping companies are being extra vigilant about sending tankers to Iranian oil terminals, and some are cutting off business with the country entirely.

China and Japan will not stop purchasing oil from Iran because of sanctions, but they are also both mindful of the potential risks involved in depending too much on the Islamic Republic as a supplier. In fact, Chinese and Japanese traders and refiners appear to be making a more concerted effort to reduce their dependence on Iran. There are a number of reasons for this and not all of them are political. For example, Japan's reduction of oil imports from Iran in 2010 has largely been offset by a surge in oil imports from Russia. This development is part of a longer term plan to rely more on new flows of crude oil coming from Russia's Eastern Siberia, which went into action earlier this year. The availability of this new supply of oil is favorable because of its geographical proximity to Japan, but also because of the reduced threat of a potential supply disruption at a choke point such as the Strait of Hormuz.

Thomas Strouse is a Middle East Analyst at Foreign Reports, a Washington D.C.-based oil consulting firm which reports on political developments in the Middle East relevant to oil markets.